Lodging Loses Altitude

After a four-year run of steady revenue growth and profitability, hotel owners and operators can expect some air to come out of the balloon of the high-flying lodging business in 2008 as supply outstrips demand and cost pressures mount. Many analysts are cautioning hotel investors that the good times are over, while economists are forecasting a significant contraction in corporate earnings over the next 12 months. “The earnings recession has already arrived,” says Merrill Lynch economist David Rosenberg.

A major hiccup by Corporate America could ultimately curtail business travel and lead to a downward trajectory for the industry. The full impact of a weakening U.S. economy on the hotel industry is an open question, but a healthy supply of new rooms due to hit the market over the next few years only compounds the situation.

“We're going to look back on this and say the year 2006 is really where the industry reached a peak, in terms of year-over-year increases in revenue per available room and bottom line profitability,” says Mark Woodworth, president of Atlanta-based PKF Hospitality Research. PKF's recent annual report on the state of the hospitality industry was tellingly titled, “For Hotels, Not as Great in 2008.”

But what a spectacular run it has been for hoteliers. Industry-wide profits topped out at an estimated $26.9 billion in 2007, eclipsing the old record of $22.5 billion set in 2000 and about double the $12.8 billion figure notched in 2003.

The strong hotel fundamentals of recent years are not expected to vanish overnight either. Smith Travel Research, a leading hospitality research firm based in Hendersonville, Tenn., forecasts revenue per available room (RevPAR) will rise 5.2% in 2008, down from 6.2% in 2007 and below the peak of 8.5% in 2005. Growth in average daily room rates, or ADRs, also is expected to slow to 5% in 2008 after climbing 6% in 2007 and 7.2% in 2006.

For the moment, major hotel markets are maintaining healthy ADRs due largely to the combination of a strong convention and meetings business and barriers to new construction. “As far as I can see, 2008 is still going to be a tough year for the group and meetings segment in terms of getting reasonable rates in major markets,” says Betsy Bair, editorial director with MeetingsNet, which publishes a group of convention and meetings magazines through Penton Business Media, publisher of NREI. “Try getting a room for a decent rate in New York City or Boston.”

More rooms on tap

But outside the major metros, years of healthy profit growth have precipitated a healthy pipeline of new hotel construction in secondary and tertiary markets. According to Smith Travel, as of October 2007 there were a total of 200,244 new rooms under construction across the country, a 25% increase over the same period in 2006.

Data shows that 53,800 new rooms are under construction in the mid-priced segment that doesn't offer food and beverage; another 45,000 rooms are underway in the upscale segment.

Particularly worrisome to analysts — another 136,000 new rooms are in the pre-planning phase, a 75.9% increase over the same period in 2006. “Supply is growing faster than demand, and our forecast is that in 2008 demand will grow by 1.5% and supply by 2.0%,” says Bjorn Hanson, a partner in the lodging and leisure practice of PricewaterhouseCoopers (PWC).

Analysts Steven Kent and Betsy Gorton with New York-based Goldman Sachs weighed in with a recent negative report on publicly traded hotel stocks. “As we look toward 2008 and 2009, our worry about accelerating supply remains, and we are adding to our list concerns regarding the demand side of the equation. With weakening operating trends, we would urge investors to move away from the group as momentum has moved away from the sector.”

A 50-year veteran of the hotel industry says the news is not surprising, given the cyclical nature of the hospitality business. “It's always exactly the same thing in cycles. Things are really great and everybody jumps in to build hotels,” says Morris Lasky, president and CEO of consultant Lodging Unlimited Inc. in Chicago. Lasky is raising a $150 million fund that targets weak-performing hotels in need of a financial turnaround.

All of the new room supply is hitting the industry at an inconvenient time, given the volatility in the debt and equity markets and the impact on consumer spending, which accounts for 70% of the gross domestic product.

The latest Federal Reserve “Beige Book” report warns of a slowing U.S. economy, which is already deflating room demand and in turn pressuring profits. Meanwhile, a survey of 50 economists conducted by The Wall Street Journal in December reveals that the risk of a U.S. recession is rising. Halfway through the month, most economists projected that GDP would grow at an annualized rate of less than 1% in the fourth quarter.

Higher energy prices are already dampening leisure travel demand, and any continued bumps in the economic road could force businesses to cut back on travel and convention bookings, driving down occupancy rates and finally forcing a compression in ADRs. According to Smith Travel, the national occupancy rate grew by only 0.1% in 2007 as compared with 3.6% growth in 2004 and 2.9% growth in 2005.

Saving funds for a rainy day

Many savvy hotel investors, like Lasky, are seizing the opportunity in advance of the downturn to selectively pick up properties that either have a track record of solid performance or provide value-add opportunities.

“The key is that all hotels and all hotel markets are not created equal because each hotel is driven by the demand generators in a finite radius around that hotel,” says Jim Merkel, president of RockBridge Capital in Columbus, Ohio. “That's why we don't take a brush to a market on a macro basis.”

Rockbridge Capital is closing on its fourth hotel investment fund, having raised $334 million in three previous funds and $200 million in its latest fund. The firm averages 30 to 40 deals a year in upscale, branded hotels in infill locations, and its investors include life companies, endowments and universities.

Woodworth of PKF says the time has passed for short-term investors hoping to make quick money by banking on rising valuations alone. “If you are an investor that likes to buy low and sell high, now is not the time for you to be getting into the hotel business because property values have been increasing at a very attractive rate the last two or three years in lockstep with industry profit growth.”

Buyer/seller disconnect?

There are signs that buyers and sellers are already drifting further apart. Hanson says that deals are already being priced based on previous years of strong performance, including RevPARs of 5% and higher. Such gains may not be so realistic in the future.

“With the volatility in the credit markets, the spread between what sellers are asking and buyers are willing to pay has increased again. So, it's a little harder to find deals where the buyer and seller have a meeting of the minds,” says Hanson.

Tom Hamm, national director of the hospitality group for San Francisco brokerage Sperry Van Ness, cites examples of a more discerning, cautionary buyer pool. His shop focuses on the economy segment of the market, where deals range from $3 million to $4 million.

Typically, he says, buyers in an up market look at the trailing 12 months of operating history when they're making pricing decisions. If their expectations are that the markets are going to slump and room revenues will be on the wane, then a buyer isn't much interested in looking so much at the trailing 12 months. Instead, the buyer is going to factor in his expectations for the next year.

“When that happens, there is a disconnect between buyers and sellers because the sellers remember the good times from the earlier period,” explains Hamm. “There's a bit of a hiatus until the buyers and sellers come together again.”

Why such cold feet?

Continued weakness in the overall capital markets is a leading cause of prospective buyers not closing on deals, says Hamm. In many cases, their financing has fallen through, or they want to make major revisions to the deal in midstream.

“We normally have multiple buyers for deals that we do, but we're finding that sometimes we're moving from the primary buyer to the next buyer in line to get the deal completed,” says Hamm.

Some institutional investors, too, are shying away from the segment. A recent quarterly market report from Prudential Real Estate Investors opined, “With hotel properties trading at rich multiples and operating fundamentals unlikely to improve, the risks in the lodging sector clearly are weighted to the downside.”

Since 2005, Hall Structured Finance, a division of Hall Financial Group in Dallas, has invested some $100 million in new hotel construction and renovation. Now, Mike Jaynes, president of the group, is adjusting to the new reality.

“We're still bullish on hotels, but like every other lender, we're underwriting a little bit more conservatively,” says Jaynes. Now deals are underwritten at 75% to 80% loan-to-values, down from the 80% to 85% level in early 2007. “We like a little more cash equity behind us with seasoned sponsors and fairly strong flags or boutiques for the right opportunities.”

Jaynes says that competition in financing hotel properties has increased significantly. “Over the years we've gained more and more competition and our spreads have compressed considerably on the pricing side.” While the company is still heavily focused on hotels, it also has diversified to other real estate sectors.

Hamm believes there will be a slowdown in sales volume in early 2008, followed by a stronger second half of the year. “The stronger buyers are going to be there, and the weaker ones are going to go by the wayside, so the lineup of buyers is going to be a little bit shorter, but they're going to be better capitalized.”

A flight to upscale assets

Kristina Paider, senior vice president of research and marketing for Jones Lang LaSalle Hotels in Chicago, says total U.S. transaction volume for 2007 for hotels valued over $10 million was more than $43 billion. Of that, $23 billion consisted of portfolio deals valued at over $600 million. The other half was single-asset transactions and smaller portfolios.

Paider expects volume to be cut in half in 2008, in the range of $25 to $30 billion, in line with previous record volumes set in 2005-2006. “While the pricing of assets is expected to soften modestly in 2008, there's no evidence of a slowing in the trend of funds investing aggressively in the hospitality sector,” says Paider.

She believes that a “flight to quality” will be investors' anthem for 2008, with the luxury and upscale segments attracting the most attention. Offshore investors will be attracted to U.S. real estate, given the weak dollar. Mexico and Latin American cities are good buys as well.

Though by no means insulated from economic or supply events, the high-end luxury segment is among the healthiest. RevPAR for Chicago's Strategic Hotels increased 7.4% in the first nine months of 2007 on its North American properties, driven by a 5.7% increase in ADR and a 1.7% increase in occupancy. Strategic owns 21 hotels with 10,218 rooms in North America and Europe.

CEO Laurence Geller expects 2008 will be choppy, with uncertainty extending through the first few months of the year. “My bet today is that 2009 and 2010 will be really good years in lodging because of lack of supply, especially at the high end.” To take advantage of foreign interest in trophy assets, Strategic plans to enter into more joint ventures in the U.S. and in Europe in coming years.

In November, Strategic closed on a $450 million joint venture with a real estate investment company affiliate of the Government of Singapore Investment Corp. Pte Ltd. The joint venture affiliate purchased a 49% stake in the company's InterContinental Chicago and Hyatt Regency La Jolla hotels.

Wanted: savvy managers

The key to making any deal work is management, and hotel managers and owners alike are facing an environment where ever-escalating costs are commonplace. PKF projects hotel operating costs to increase by 4% in 2008, or nearly double the expected pace of inflation.

Labor accounts for the greatest percentage (45%) of total costs, and low national unemployment rates continue to put pressure on wages and make finding qualified employees more difficult.

Indeed, experienced managers are at a premium. “It's a business that runs every day,” says Lasky. “If you run it right, you'll make more money than in any other type of real estate because it's the only business that you walk in and every day the rate is different.”

Merkel says buyers should focus more on operating issues when conducting due diligence, citing examples of sellers who lighten their expenses to pump up positive margins on a short-term basis.

“You can't just look at expenses on a historical basis. The reality may be quite different,” says Merkel. “You've got to do your due diligence and understand the underlying performance of the hotel under the new regime and the new operating model to make good decisions.”Ben Johnson is a Dallas-based writer.

FIVE MOST ACTIVE MARKETS FOR HOTEL CONSTRUCTION*

America's top tourist destination, Las Vegas, leads the list of cities with new hotel rooms under construction. The $1.4 billion Encore hotel-casino will open in late 2008.

Market

Number of rooms

% of Existing Supply

Las Vegas

14,329

9.7

New York

8,557

10.5

Washington, D.C.

6,474

7.0

Chicago

6,195

6.1

Phoenix

5,756

11.0

*As of October 2007Source: Smith Travel Research

Hilton's new chief has the world on his mind

Change is the order of the day at the world's largest hotel organization, Hilton Hotels Corp. Only days after private equity giant The Blackstone Group completed its $26 billion privatization of the company in October, many industry veterans were shocked to learn that outsider Christopher Nassetta would fill the shoes of retiring president and CEO Stephen Bollenbach.

Nassetta, 45, served as CEO of Bethesda, Md.-based Host Hotels & Resorts for the past 12 years. The task facing him is a daunting one: maximize the value of Hilton's holdings while taking the company down some new but strategically slippery paths. A first order of business is managing through Blackstone's planned $9 billion CMBS offering — the largest ever — in the first quarter of 2008 to finance the Hilton buyout.

“Chris is not only an incredibly smart and talented executive, but he really cares about people,” says Blackstone senior managing director Jonathan Gray, engineer of the Hilton deal. “That is an important quality when you consider he'll lead a business with more than 100,000 employees in 75 countries.”

During his first week on the job in December, Nassetta spoke with NREI about Hilton's future and his role guiding the enterprise.

NREI: Why did you take on your new role at Hilton?

Nassetta: This is a great opportunity to work with two terrific organizations, Hilton and Blackstone. I have known Jon Gray and others as both friends and partners over the past 15 years and can say from personal experience that they add value to the businesses they invest in. Their support will lead to greater opportunities for our business. And, of course, Hilton is one of the most respected companies in the world. It is a terrific company with a powerful collection of brands and a commitment to quality and customer service.

I see my job as taking this great company with its legendary brands to the next level. International growth will be a priority as this part of our business is in the early stages of development due to the fairly recent acquisition of Hilton International. I really believe that Blackstone and Hilton are a perfect combination and look forward to creating value for our brands, owners and team members and to strengthening Hilton's position as the pre-eminent global hospitality company.

NREI: Why do you feel you are the right person for this job?

Nassetta: My combination of experience in finance, hotels and real estate, as well as my relationship with Blackstone, makes this a good combination. I've been on the hotel ownership and franchisee side, so I understand the needs and issues owners have. As Hilton continues to grow its franchise and management business, this perspective will be important to the company's future growth.

NREI: What is your No. 1 priority?

Nassetta: My goal is to further Hilton's position as the pre-eminent global hospitality company. To do that, in addition to maintaining the momentum of our domestic growth, international growth will be a priority. We've already entered into development deals in the fast growing markets of India, China and the UK. We are also targeting expansion of our brands into parts of Europe including Russia, Italy, Spain and Turkey. Our current strategy is to open 1,000 new hotels internationally in 10 years along with 1,000 in the U.S in five years.

Another priority will be the integration of LXR Luxury Resorts & Hotels into Hilton's other luxury brands. We can provide a real boost to these brands by integrating some of Blackstone's world-class assets. Developing appealing, luxury and boutique brands and reigniting the Hilton brand are important goals. — Ben Johnson